How to Deduct Depreciation on Rental Property: A Landlord’s Definitive Guide

Deducting depreciation on rental property is a cornerstone of real estate investing tax strategy, allowing you to recover the cost of your investment over its useful life. To deduct depreciation, you essentially spread the cost of your property (excluding land) over a period of 27.5 years for residential rental properties. You determine the depreciable basis, calculate the annual depreciation amount, and then report it on Schedule E (Supplemental Income and Loss) of your tax return, reducing your taxable rental income.

Understanding Depreciation: The Key to Tax-Savvy Landlording

Depreciation, in essence, acknowledges that your rental property is slowly “wearing out” or losing value over time. The IRS allows you to deduct a portion of that loss each year, even though you haven’t physically spent that money. This deduction can significantly lower your tax burden and boost your cash flow. Let’s dive into the nitty-gritty of how it works.

Determining Your Depreciable Basis

The depreciable basis is the foundation of your depreciation calculation. It’s essentially the cost of the property you can depreciate. Here’s how to figure it out:

1. Purchase Price: Start with the price you paid for the property.
2. Closing Costs: Add certain closing costs, such as legal fees, recording fees, and transfer taxes. These costs are considered part of your investment in the property.
3. Subtract Land Value: Crucially, you cannot depreciate land. The IRS assumes land doesn’t wear out. You’ll need to allocate a portion of the purchase price to the land. This can be done by looking at your property tax assessment (which often breaks down land and building values) or obtaining an appraisal that separately values the land.
4. Allocate Personal Property: Furniture, appliances, and other personal property with a useful life of more than one year are also depreciable, but they are often depreciated over shorter periods (typically 5 or 7 years). Make sure to separate the value of these items.

The result is your adjusted basis, which is the amount you’ll use for depreciation.

Calculating Annual Depreciation

The most common method for depreciating residential rental property is the Modified Accelerated Cost Recovery System (MACRS), using the straight-line method. Here’s the simple formula:

(Depreciable Basis) / (27.5 years) = Annual Depreciation Expense

For example, if your depreciable basis is $275,000, your annual depreciation expense would be $10,000 ($275,000 / 27.5).

Reporting Depreciation on Schedule E

You’ll report your depreciation expense on Schedule E, which is where you report your rental income and expenses. You’ll need to provide information such as the date you placed the property in service (when it was first available for rent), the depreciable basis, and the depreciation method used. Keep detailed records and consult with a tax professional if needed, especially if you’re dealing with complex situations like improvements or changes in use.

Frequently Asked Questions (FAQs) about Rental Property Depreciation

Here are some of the most frequently asked questions about depreciating rental property, answered with expert insight:

1. What happens if I make improvements to the property after I purchase it?

Improvements, such as adding a new roof, renovating a bathroom, or adding an addition, are treated as separate depreciable assets. You’ll depreciate the cost of these improvements over 27.5 years, starting from the date the improvement is placed in service. Keep meticulous records of all improvement costs.

2. Can I depreciate appliances and furniture I include in the rental?

Yes, you can depreciate personal property, like appliances and furniture, used in your rental property. However, instead of the 27.5-year schedule, these items are typically depreciated over 5 or 7 years, depending on the specific asset class, using the General Depreciation System (GDS).

3. What if my rental property is vacant for a period of time? Can I still take depreciation?

Yes, you can generally still take depreciation even if your property is temporarily vacant, as long as it remains available for rent. The key is that you must have placed the property in service as a rental, and you must be actively trying to rent it out.

4. What is “recapture” of depreciation, and how does it affect me when I sell the property?

Depreciation recapture is when the IRS taxes the amount of depreciation you’ve deducted over the years when you sell the property at a profit. This is taxed at your ordinary income tax rate, up to a maximum of 25%. It’s a way for the IRS to recover the tax benefits you received through depreciation. It can be a significant tax liability, so factor it into your long-term financial planning.

5. What is the difference between depreciation and repairs?

Repairs are expenses that maintain the property in its current condition (e.g., fixing a leaky faucet, patching a hole in the wall). These are deductible in the year they are incurred. Improvements, on the other hand, increase the value of the property or extend its useful life and are depreciated over time. The distinction is crucial for accurate tax reporting.

6. Can I claim depreciation on a property I live in part-time and rent out part-time?

Yes, but only on the portion of the property used as a rental. You’ll need to allocate expenses (including depreciation) based on the percentage of time the property is used for rental purposes. For example, if you rent out the property for 6 months of the year, you can only depreciate 50% of the depreciable basis.

7. What if I don’t claim depreciation one year? Can I catch up later?

While you can’t go back and amend prior year returns to claim missed depreciation, the IRS still requires you to reduce your basis in the property by the amount of depreciation you should have taken, whether you actually claimed it or not. This is known as “allowed or allowable” depreciation, and it impacts your gain or loss when you sell the property.

8. What records do I need to keep for depreciation purposes?

Keep detailed records of the following:

• Purchase price and closing costs
• Allocation of value between land and building
• Dates of any improvements and their costs
• Documentation of personal property included in the rental
• Rental agreements and records of vacancy periods

Good record-keeping is essential for surviving an IRS audit.

9. I inherited a rental property. How does depreciation work in that case?

When you inherit property, your basis is typically the fair market value of the property on the date of the decedent’s death. You’ll then use that fair market value (minus the land value) as your depreciable basis.

10. What if I convert my primary residence into a rental property?

When you convert your primary residence into a rental property, your depreciable basis is the lesser of the adjusted basis of the property or its fair market value on the date of conversion. This rule prevents you from claiming depreciation on the increase in value that occurred while you lived in the property.

11. How do I handle depreciation if I sell the rental property?

When you sell your rental property, you need to calculate your adjusted basis by subtracting all the depreciation you’ve taken (or should have taken) from your original basis. The difference between the selling price and the adjusted basis is your gain or loss on the sale. Remember that depreciation recapture will likely apply to the gain.

12. Should I hire a cost segregation study?

A cost segregation study is an engineering-based analysis that identifies property components that can be depreciated over shorter periods (5, 7, or 15 years) rather than the standard 27.5 years for residential rental property. This can result in significantly larger depreciation deductions in the early years of ownership. It’s generally beneficial for larger, more complex properties. Consult a qualified cost segregation specialist to determine if it’s right for you.

Mastering Depreciation: Your Path to Rental Property Success

Understanding and properly claiming depreciation is crucial for maximizing the profitability of your rental property investments. While the rules can be complex, diligent record-keeping, accurate calculations, and consultation with a qualified tax professional will ensure you’re taking full advantage of this valuable tax deduction. By doing so, you’ll not only lower your tax burden but also build a stronger financial foundation for your real estate portfolio. Good luck and happy investing!